3/31/2008 @ 6:00AM

Getting Over China

An excerpt from The China Price: The True Cost of Chinese Competitive Advantage by Alexandra Harney ($26, Penguin Press, 2008).

Sam slides behind the wheel of his new black Honda and noses the car into Friday morning traffic. It’s a hot, sunny June morning in Changsha, capital of central Hunan province, and everything seems to be falling into place.

Beside him sits his wife Jasmine, eight months pregnant and radiant in a yellow dress. High school sweethearts, they married at 21. Now, at 23, they’re about to start a family in a brand new gated community. Sam, whose name, like those of other members of his family, has been changed, is looking forward to making use of the development’s two swimming pools and basketball court. In a few years, they plan to build a house in the mountains where they can entertain family and friends on the weekends.

The Honda heads out of town into the verdant countryside toward Jasmine’s father’s towel factory. Towels, a key Hunan export, have been the family’s mainstay for nearly two decades. Sam married into the job of overseeing the plant’s $5 million in annual sales.

The road narrows and Sam slows to accommodate farmers swaying on bicycles. On either side are rice paddies and family farm plots. That’s where the first sign of changes ahead appears. Trees.

Several years ago, farmers on the outskirts of Changsha realized they could make good money growing trees. They planted family plots in Hunan’s fertile soil and hung signs on trees near the road advertising their cellphone numbers. Soon enough, the farmers who worked at Sam’s factory were demanding higher wages, because they could make better money from trees.

The factory, which relies mostly on local labor, had no choice but to capitulate. “Salaries are going up and up,” Sam sighs from behind the wheel. The labor market has tightened, too, as other factories have opened in the area. The government is hiking the minimum wage in Changsha. Sam figures he has three, maybe five more years before his factory loses its competitive edge.

This is where the next boom in Chinese manufacturing is supposed to take place. Conventional wisdom holds that rising costs of everything from labor to land on the coasts are driving factories in labor-intensive consumer industries deep into the country’s heartland, to provinces like Hunan, in pursuit of lower prices. But in China’s fast-forward economy, investors are finding things aren’t as cheap or plentiful as they used to be. And the workers aren’t pushovers, either.

Thanks in part to Chinese government policies, the country’s labor-intensive export factories have for most of the past decade operated almost in defiance of the rules of economics, enjoying stagnant wages, ample coastal land near the ports, and a seemingly endless supply of pliant labor. Government incentives, including subsidized electricity and generous tax breaks, have helped keep the ordinary forces of a market economy at bay. The low prices that this produced earned China the enviable position of the world’s dominant producer in a huge variety of products. But this fortuitous situation couldn’t last. “This is an advantage that expires,” says Arthur Kroeber, managing director of Dragonomics, a research and advisory group that specializes in the Chinese economy.

Jonathan Anderson, former head of Asian economics at investment bank UBS, calls it “the end of China’s supposed absolute manufacturing domination.” He argues that China will revert to a more normal trading pattern, where it gains market share in some areas and loses it in others. For any other country, this would be a natural assumption, devoid of drama. For the world’s emerging superpower and a world hooked on its cheap products, it is anything but.

Sam’s factory is a series of gloomy, medieval rooms arranged in a U-shape, a century behind the modern plants on the coasts. In one dark, humid room, a man uses a long metal pole to stuff tan towel fabric into a hole in the side of a machine. The machine spits out the towels bleached white. Another room houses enormous towel-printing machines and buckets of viscous paint. It yet another room sit rows of sewing machines and stacks of finished towels.

The room where the factory greets customers is equally spartan. Lined with black overstuffed sofas and matching chairs, it buzzes with horseflies. The window sills are still wrapped in plastic from the manufacturer. Off this room is the boss’ office and a tiny, windowless showroom hung with dozens of beach towels. If you have ever bought a towel from a small store near the beach, it probably came from a factory like this.

This is the oldest towel factory in town. In 1987, Sam’s father-in-law, Fang, was the village chief. He decided to go into business making towels and exporting them. Fang borrowed the equivalent of just under $40,000 at today’s exchange rates, hired 20 of his neighbors and started making towels that he sold to foreign customers through a trade association. Over time, the factory expanded to employ 400 people, producing 20,000 towels a day. Fang wouldn’t even consider an order smaller than 2,000 towels. Business was good in the early days of China’s export manufacturing boom: as recently as 1996, Fang was earning margins of 20%.

But, inevitably, competition arrived. Towel manufacturing took off, not only in Hunan but around the country. Cotton prices soared. So did wages, especially as the tree business matured. By the summer of 2006, when we spoke, Fang claimed he was paying his workers $105 a month, a wage comparable to what they might have earned in coastal areas. It’s unlikely Fang is actually paying his workers this much. But it’s clear that the legal minimum wage in Changsha is rising.

Labor, which once accounted for 5% of his costs, had risen to 15%, Fang said. But the surge in towel factories–Fang counted 20 main competitors–was driving prices down every year. “Wages are going up, prices are coming down,” Fang said matter-of-factly, sitting in the factory’s fly-infested conference room. “Our profits are smaller.”

It was the refrain of every Chinese factory. Like many other industries where competition in China beat prices down to next to nothing, Chinese towel makers were now facing international sanction because of their low prices. The U.S. has imposed quotas on Chinese towel imports. Taiwanese towel makers, outraged by the dominance of Chinese towels in their domestic market, took Beijing to the World Trade Organization in 2006.

Fang is unmoved by the changing market situation, perhaps because at 50 years old, he hopes to hand over the business to his son-in-law. Perhaps it’s because he can still make a living here in Hunan.

Moving the factory elsewhere would be difficult because he’d have to train another group of workers. He has employees who have been working for him for five years, an eternity in coastal China. “We’re considering the situation,” he says.

Fang is tall, with a flat face and a thick Hunan accent, delivered through teeth etched with dark brown stains. At meals, Fang rolls up his pants to his knees, exposing two skinny, hairless calves. He likes a strong drink, especially with friends, and is partial to the clear local liquor that burns going down. He works a seven-day week, starting each day at 7:30 a.m., and smokes three packs of cigarettes a day.

Sam, however, is watching the trends in global manufacturing carefully. “Within 15 years, because costs in China are too high, many factories will open in India and Pakistan, and also in Vietnam. In these places, costs are very cheap–the cost of workers, of yarn,” he says.